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1. Context

1.1. Learning outcomes

After studying this text the learner should / should be able to:

1. Understand the context of the derivative markets.

2. Describe the basic fundamentals of the derivative markets.

1.2. Introduction

The purpose of this section is to provide the context of the derivative markets, which is the financial system and its financial markets, and the commodities markets. The following are the subsections:

• The financial system in brief.

• Ultimate lenders and borrowers.

• Financial intermediaries.

• Financial instruments.

• Spot financial markets.

• Interest rates.

• The derivative markets.

1.3. The financial system in brief

The financial system is essentially concerned with borrowing and lending and may be depicted simply as in Figure 1.

financial system (simplified)

Figure 1: financial system (simplified)

The financial system has six essential elements:

• First: ultimate lenders (surplus economic units) and borrowers (deficit economic units), i.e. the non-financial economic units that undertake the lending and borrowing process.

• Second: financial intermediaries which intermediate the lending and borrowing process; they interpose themselves between the lenders and borrowers.

• Third: financial instruments, which are created to satisfy the financial requirements of the various participants; these instruments may be marketable (e.g. treasury bills) or non-marketable (e.g. retirement annuity).

• Fourth: the creation of money (= deposits) when banks loans are demanded and satisfied; banks have the unique ability to create money by simply lending because the general public accepts bank deposits as a medium of exchange.

• Fifth: financial markets, i.e. the institutional arrangements and conventions that exist for the issue and trading (dealing) of the financial instruments;

• Sixth: price discovery, i.e. the price of shares / equity and the price of money / debt (the rate of interest) are "discovered" (made and determined) in the financial markets. Prices have an allocation of funds function.

We touch upon these elements of the financial system below, because they serve as the context and foundation of the derivative markets.

1.4. Ultimate lenders and borrowers

The ultimate lenders can be split into the four broad categories of the economy: the household sector, the corporate (or business) sector, the government sector and the foreign sector. Exactly the same non-financial economic units also appear on the other side of the financial system as ultimate borrowers. This is because the members of the four categories may be either surplus or deficit units or both at the same time. An example of the latter is government: the governments of most countries are permanent borrowers (usually long-term), while at the same time having short-term funds in their accounts at the central bank and/or the private banks, pending spending.

1.5. Financial intermediaries

Financial intermediaries exist because there is a conflict between lenders and borrowers in terms of their financial requirements (term, risk, volume, etc.). They solve this divergence of requirements and perform many other functions such as lessening risk, creating a payments system, monetary policy, etc.

Financial intermediaries may be classified in many ways. A list of the financial intermediaries found in most financial systems, according to our categorisation preference, is as shown in Box 1.

The main financial intermediaries (or categories) and their relationship to one another may be depicted as in Figure 2.

MAINSTREAM FINANCIAL INTERMEDIARIES

DEPOSIT INTERMEDIARIES

Central bank (CB) Private sector banks

NON-DEPOSIT INTERMEDIARIES

Contractual intermediaries (CIs)

Insurers

Retirement funds (pension funds, provident funds, retirement annuities)

Collective investment schemes (CISs)

Securities unit trusts (SUTs) Property unit trusts (PUTs) Exchange traded funds (ETFs)

Alternative investments (AIs)

Hedge funds (HFs)

Private equity funds (PEFs)

QUASI-FINANCIAL INTERMEDIARIES (QFIs)

Development finance institutions (DFIs) Special purpose vehicles (SPVs) Finance companies Investment trusts / companies Micro lenders Buying associations

BOX 1: Financial intermediaries

 
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